Debt Settlement vs. Credit Counseling

Life is difficult for anyone struggling to meet spiraling credit card payments. Help could come in the form of paying a debt settlement agency to help negotiate a way out, or finding a nonprofit credit counseling agency that can guide you to an affordable solution.

“Credit counseling can be thought of as education and coaching, where debt settlement is negotiating to lower the individual’s debt amounts or borrowing terms,” said Mary Sasmaz Ph.D., a CPA and Assistant Professor at the Weatherhead School of Management at Case Western Reserve University in Cleveland.

When faced with this situation, you need to be familiar with how the two approaches work, and especially how they differ. Choosing wisely can lift that oppressive burden of debt, but choosing poorly could hurt your credit rating, damage your finances and leave you struggling.

What Is Debt Settlement?

The Consumer Financial Protection Bureau (CFPB) states that debt settlement companies offer “to remove your debts to lenders or debt collectors for a fee.”

Sasmaz put it this way, saying: “A company is hired to try to negotiate your debt in terms of amount and/or borrowing rate. They build a case and present it to the individual’s creditors.”

Instead of making monthly payments to your credit card issuers, you deposit funds in an escrow account that you control and own, but the debt settlor can use. When the account grows to a certain size – usually 50% of what you owe – the debt settlor contacts your card companies and proposes a settlement.

If the card company agrees to the proposal, the debt settlement company receives a fee that can be a set amount or, more likely, a percentage of the original debt amount. Money then is paid to the debt settlement company and is not use for your debt.

The strategy relies on the assumption that creditors or debt collectors will prefer to recover something on unsecured debt and will accept a big reduction in what is owed in exchange for said payment. Note: Creditors don’t always accept this idea, and some refuse to deal with debt settlors.

Debt settlement can be risky and costly. The costs come in two forms: fees the debt settlement company charges and penalties and interest the credit card issuer will add to your balance if you stop making monthly payments. Consumer watchdogs often advise against doing business with debt settlement companies, which are usually for-profit businesses that are mostly interested in making money from you.

“Negotiations are not guaranteed so it’s possible to pay for the negotiation service but then be unsuccessful in gaining any relief,” Sasmaz  said. “Having had negotiated debt will be reported as part of your credit report so it can impact credit scores, and failure to stick with any negotiated plan (i.e. timely payments and amounts) would have significant negative implications on credit scores.”

Consider the advantages and disadvantages of debt settlement before deciding whether to contract with a company.

Pros of Debt Settlement

Pros of using a debt settlement approach include:

• If an agreement is reached (a big if), you clear your debt for less than you owed.
• This allows you to become debt free sooner than if you just made payments without the settlement.
• Once the debt is settled, credits and collectors will stop calling you, and the threat of a collection lawsuit disappears.
• Settlement companies cannot charge a fee until they have settled at least one of your credit card debts.

Cons of Debt Settlement

Debt settlement as a strategy is high stakes poker. Several concerns should be weighed:

• Debt settlement companies often charge high fees but can’t promise results.
• Even if they are successful in reducing debt, the fees and the unpaid interest and late payment charges on the debt can add to what you initially owed, reducing your actual savings.
• Settlement will damage your credit rating, since credit card issuers or debt collectors are likely to report the amount they forgave to the nation’s three large consumer credit reporting agencies.
• Taxes are another problem: the IRS will treat the amount you didn’t pay creditors as income in the year the debt was settled, requiring that you pay taxes on it. Before entering a debt forgiveness settlement, talk to an accountant or tax lawyer to better understand the consequences.

» Learn More: How Long Does Debt Settlement Affect Your Credit?

• Be wary of debt settlement scams. If the settlor demands you pay the full fee for its services upfront, look for another company. The CFPB reports that fees cannot be paid unless three things happen: a successful result is reached, an agreement is made between you and the creditor or debt collector and you have a payment to the credit.
• Also avoid companies that say they are using a “new government program” to eliminate credit card debt or those that tell you to stop communicating with your creditors.
• Ensure whoever you are talking to has proper accreditation from the American Fair Credit Council (AFCC) or the International Association of Professional Debt Arbitrators (IAPD).
• If the debt settlor can’t win over your creditors and eliminate all your debt, the holdout creditors who refused to settle could wipe out whatever savings your realized with fees and interest charges.

It’s wise to ask a lot of questions before using a debt settlement company.

Who Is Debt Settlement Best for?

Debt settlement is best for those with significant unsecured debt – think more than $10,000 — who are behind on payments. If you are already 3-to-6 months delinquent on payments, this approach might help.

It is designed for those looking to avoid bankruptcy but it will mean accepting a lowering of your credit score, which can remain for seven years. If your credit score Is already below 500, debt settlement could be an option, but you will need to be able to have the discipline to save regularly to make a lump-sum payment to creditors.

What Is Credit Counseling?

Credit counseling is an often-free service offered by nonprofit debt agencies to help people manage their money, develop and live from a monthly budget and understand the different solutions available for dealing with debt, including credit card debt.

“The individual is coached to make a plan that if they stick to it, will help them get out of debt,” Sasmaz said.

Certified credit counselors try to accomplish two things. First, they review your debt and try to help you understand how your finances became so imbalanced and how to avoid falling into unmanageable debt again. As they ask questions and review your accounts, they make suggestions about how you might better manage credit.

Second, they’ll try to create a plan that lowers your monthly payment by reducing the amount of interest owed. Debts are usually paid off in three to five years.

“Having significant levels of debt will negatively affect credit scores but credit scores should improve as the debt is reduced,” Sasmaz said.

Fees may apply once the plan is set up and you agree to it.

“Fees, if any, for services related to credit counseling will typically be less than those for debt settlement,” Sasmaz said.

Yes, you’ll live a more austere life during the repayment period. The credit counselor will combine all your debts into a single monthly payment which the counselor will collect and distribute to your creditors.

Pros of Credit Counseling

These include:

• Credit counseling creates a manageable debt payment plan tailored to your personal financial and debt situation.
• During your initial consultation, the counselor will review your debts and your income to determine whether a debt management plan will work for you.
• If invoked, creditors will agree to the plan that will see your debts consolidated into a single monthly payment.
• If you make payments on time, you credit rating won’t suffer.
• Plans usually focus on unsecured credit card debt, but counselors might be able to include medical and department store debt in the mix.
• Unlike debt settlors, most credit counselors are nonprofit companies. They will charge a fee, but it is generally lower than for-profit companies. Ask about debt management fees before you join the program.

Cons of Credit Counseling

There are concerns about credit counseling, but most of the concerns are related to meeting the responsibility of the agreement, which makes them short-term pain for a long-term gain:

• Debt management plans take time. Your debts aren’t settled or discharged, so it might take 3-5 years to pay them off
• If you miss a payment, the card companies can eliminate the concessions they offered to start the program.
• You are required to put away all but one of your credit cards and that one is only to be used in emergencies.
• During that time, you will probably need to forgo luxuries and direct a sizable part of your income to the debt payment plan.

Who Is Credit Counseling Best for?

Credit counseling is best for those who would benefit from a structured, affordable plan to regain financial stability. It is a great help to those seeking lower interest rates on their debt, debt consolidation or help with budgeting so the problem does not repeat.

In addition, those who prefer no-charge or low-cost support with budgeting to avoid debt would benefit from counseling. The counselor listens to you, assesses your situation and does his or her best to come up with the best plan for your situation.

Choosing Between Debt Settlement and Credit Counseling

Credit counseling is usually the best alternative if you can afford the monthly payments and have the discipline to live on a strict, defined budget for several years. The amount of time it will take depends on your income, your fixed expenses, the debt management plan your counselor devises with your creditors and your commitment to making every required payment on time.

Debt settlement can be faster than a debt management plan, but it also can be expensive. Settlement company fees are often high and the damage to your credit score is considerable, restricting your ability to borrow in the future at market interest rates. But it can be faster than a debt management plan.

Because the fees are high and debt settlement companies are sometimes exposed as scams, you might consider trying to negotiate a settlement directly with your creditors. Whether you use a settlement company or go it alone, you generally have to stop making payments before you can get a creditor to agree to a debt reduction. You also must have money in escrow or in an account available to pay your creditors if they agree to a reduction in debt.

Consider Morton, 40, a foundry worker who earns $45,000 a year and has $15,000 in credit card debt. He can only afford minimum monthly payments on his four credit cards and each month his debt increases as he struggles with an average 22% APR on his unpaid balances. He knows he needs a plan.

A credit counselor might be able to consolidate his debt, lowering his interest to an APR of 6% to 8% while requiring that he pay down principal every month. A debt settlement company would tell him to stop making any payments and instead contribute money to an escrow account that it will use to try to settle his debt.

Morton feels that if he finds a second job, he should be able to work through a debt management plan. After reviewing the pros and cons, he opts to see a credit counselor.

Alternative Debt Relief Options

If neither credit counseling or debt settlement are right for you, other approaches to eliminate the debt can be pursued. They might not all be pleasant, but the long-term benefit would be significant.

You could call your credit card company and negotiate a repayment plan that could reduce the total amount owed and paid. If you choose this option, be humble; then be responsible about meeting the terms that are set. You could even ask for the credit card company to reduce your interest rate, which reduces the total due.

A second job through part-time work or the gig economy would bring in extra money that could be used solely for debt.

The debt snowball method means paying the smallest debt first, and so on until all debts are paid. The debt avalanche pays the debt with the highest interest rate first, then continuing until all debts are paid.

The best way to attack the debt is by being responsible and faithful to any approach you choose, then act responsibly after.

“Regardless of the approach, it is imperative that individuals reflect and adjust spending habits so that they do not acquire additional debt,” Sasmaz said.